Portfolio Insight – Legal & General Investment Management
What did LDI strategies look like 20 years ago?
Guy Whitby-Smith: LDI was built on a core premise that liabilities are bond-like. Therefore, investing in bond-like assets would accurately match the risks of your liabilities. This principle has persisted throughout LDI’s evolution.
The earliest LDI strategies were bond based and had limited leverage. This meant that, from a capital perspective, they were expensive as a lot of a scheme’s assets were used to match its liabilities. This limited the appeal. Only well-funded schemes had enough assets to invest in bonds that matched their liabilities. So, overtime more leverage was used in LDI portfolios,
which initially focused on
interest rate swaps. This opened up LDI to a greater range of clients, as less well- funded schemes could match-off their risks and liabilities.
Another feature we saw 20 years ago was a focus on accurately matching every lia- bility. It was not uncommon to match 50 years of liabilities using 50 swaps, one for each year of cashflow.
Schemes also tried to accurately hedge inflation using limited price indexation swaps that match the caps and floors of the precise pension scheme linkages. That has changed quite a lot over the years with a move away from such accu- rate hedging to a more pragmatic approach of capturing the broad sensitivi- ties from the liabilities to interest rates and inflation. Initially, swaps were used to match liabili- ties where leverage was needed because they yielded more than gilts. In 2008, the financial crisis changed that with gilts subsequently yielding more than swaps. That brought to the fore a greater focus on using gilts to match liabilities and gilt repo when leverage was needed. That has persisted and become the heart of LDI strategies.
How has LGIM’s approach to LDI changed and how has your thinking evolved?
Robert Pace: As we heard from Guy, there has been significant change during the past 20 years, but LGIM’s philosophy and core beliefs have been remarkably con- stant: taking a long-term view and contin- uously adding incremental value for our clients, which you could summarise as efficient risk management.
Looking at the nature of our LDI offering and how that has evolved: we have more than 800 LDI clients. We definitely did not start out with that many.
It has been important to be flexible – whether that be gilts/swaps, LIBOR or CPI – to put us on the front foot and add value in response to those changes. It is also about being able to offer a tai- lored solution for our clients. A good example is that we operate an enhanced LDI service for more than 100 of our mul- ti-investor pooled fund clients, where we use multiple pooled fund building blocks with a segregated risk management solu- tion on top. This means we are managing to a liability benchmark and able to deliver many other enhancements depending on a client’s objectives, whether that is a funding level trigger, completing around other assets with interest rate sensitivity or some other strategic aspect. We have made LDI inclusive for more cli- ents and consistently improved our offer- ing, made possible by technology and the scale we have in this area. The final point is responding to a desire from clients for greater delegation. His- torically, we looked to add value by provid- ing trade ideas but that had its govern- ance challenges and as such clients were keen to work with us to incorporate extra flexibility within mandates. For bespoke mandates we will typically always include discretionary switching, where we have historically added three to four basis points per annum of extra value. That is material when you consider it in pound terms, £400k for £1bn of hedged liabilities.
That has enabled us to take advantage of opportunities and over the past few years,
For professional clients only
THE PANEL:
Guy Whitby-Smith is head of solutions portfolio management at LGIM
Robert Pace is senior solutions strategy manager at LGIM
Emma Rayner is head of LDI distribution at LGIM
it has been excellent to have that extra del- egation. The extra supply of government bonds has afforded us the ability to add value whilst also improving the shape of the hedge.
What are the biggest lessons you have learned during the past 20 years? Whitby-Smith: Firstly, that schemes need to focus on the risk management aspects of an LDI strategy, especially when designing it.
If we look at what has happened in the market during those 20 years, at the turn of the millennium gilts yielded 5%, but have since fallen steadily to around 0% last year. Low interest rates during that period dis- couraged some schemes from pursuing hedging. Where schemes fared better is, rather than taking a view on calling the direction of interest rates, they steadily averaged in and increased their level of hedging, year-on-year.
The second theme is first mover advan- tage. This is particularly significant for pension schemes due to their c.£2trn of assets, which give them a profound effect on whatever market they move into. It is better to be in the initial phase of that than the middle or backend.
An example of this was when central clearing became mandatory. The result- ing rise in cleared swap volumes impacted pricing, so the advantage of early adop- tion was significant. We also saw this play out in the move to SONIA from LIBOR. A lot of pension schemes had sizable LIBOR positions to
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